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“Triple Threat” Investing Opportunity
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Daily
If you’ve ever played organized
basketball, then you’ve probably heard of the “triple threat.” The idea is
that when a strong player receives a pass, he (or she) should be in a
ready (knees slightly bent) position, poised for multiple avenues of
attack.
It’s called the “triple threat”
because there are three different ways of moving toward the goal —
shooting, passing or dribbling.
Well, my beat is long-term
investing (rather than basketball). So how does the idea apply in that
regard? Basically, the “triple threat”concept represents a company’s
ability to perform in at least one of three critical areas.
When excelling in these three
areas, a company has increased likelihood of producing incredible returns
for shareholders. Companies that can sustain “triple threat” performance
over long periods of time are valuable and very hard to come by.
Start From the
Top
When I do a “triple threat”
analysis, the first item I consider is top-line performance, also known as
revenue performance (i.e. how much money is coming in). One of the things
that makes “triple threat” companies so powerful — and so rare — is the
presence of top-line revenues that are not just growing, but actually
accelerating in their growth. Specifically, a company might grow sales by
5% in year one… 8% in year two… 10% in year three, and so on.
If a company grew its top line
(annual revenues), for example, by estimated amounts of 24%, 2% and 1% in
the years 2007-2010 (based on forward projections), I would be concerned.
While revenues are growing through the cycle, they are slowing down. So,
our example does not qualify as a true “triple threat” contender in the
first category.
Margin Improvement: No
Excuses
The second “triple threat”
element relates to operating margin. Well-run companies should be able to
improve their operating margin consistently over time. As Investopedia
defines it, “Operating margin gives analysts an idea of how much a company
makes (before interest and taxes) on each dollar of sales. For example, if
a company has an operating margin of 12%, this means that it makes $0.12
(before interest and taxes) for every dollar of sales.”
The idea is, as sales grow —
think of that accelerating top line we just talked about — a larger
percentage of revenue flows through to net earnings (as opposed to being
spent on wages, equipment, raw materials and other things).
Operating leverage is
based on the idea of generating higher revenues (via increased sales,
higher pricing, or both) without a comparable increase in the cost of
doing business. Higher revenues without commensurately higher costs means
greater profit.
In a healthy economic environment
where revenues are accelerating, “triple threat” companies can increase
their operating leverage (and thus their operating margin overall)
meaningfully over time through a number of tried-and-true strategies.
But in challenging times (like
the major recession we just encountered), many companies take dramatic
steps to minimize the impact of weaker sales. To my surprise, even with
sales falling off a cliff, companies were able to improve operating
margins through activities like cost-cutting, inventory reductions,
layoffs and other general productivity improvements. This propelled
earnings in the second half of 2009 and could have further impact on the
first few quarters of 2010.
align=left>Shareholder-Friendly
So far, we have worked our way
down from the “top line” (revenues) to the operating level and “bottom
line,” where profits (i.e. earnings) are tallied. The distinction between
earnings and earnings per share (EPS) is now worth highlighting, since the
last component of the”triple threat” analysis is based on the number of
shares outstanding. A smart and attractive company is one that buys back
enough outstanding shares so that the share count is reduced. By doing
that, EPS, which is calculated as earnings divided by the number of shares
outstanding, increases.
While some companies periodically
announce major share buyback programs to reduce their share count, other
companies are always in the market buying up shares, just to avoid EPS
dilution that comes from having too many shares outstanding.
Do you remember the heyday of the
Internet bubble, when companies issued their employees thousands of stock
options as a cheap form of compensation? Those (converted) options and
employee-issued shares caused significant earnings
dilution —
the phenomenon of having to split up a finite pool of earnings over a
bigger and bigger pool of shares. And while the Internet bubble long ago
went bust, most companies still include stock options and share issuance
as a core part of employee performance incentives. Point being, there is
always natural earnings dilution that should be addressed by occasional
share buybacks.
Better yet, a true “triple
threat” company is actively and routinely buying up shares of its stock
with the free cash flow (another very important metric) that it
generates. A long-running, consistent share buyback program will increase
the EPS growth rate, and make a stock more attractive to investors.
Few companies can sustain “triple
threat” results for more than a short period of time, and young (or small)
growth companies are more likely to be “triple threat” contenders than
large and mature ones (though this is not always the case). Cyclical
industrial type companies can also move in and out of “triple threat”
status, depending on where they are in the overall cycle.
When analyzing a company for its
long-term investment potential, it’s helpful to determine whether there is
a potential “triple threat” scenario in the works. Understanding (and
paying close attention to) core concepts like top-line acceleration,
margin expansion, and consistent share-count reduction can make you a
better stock-picker and investor.
Taking the Next Step to
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